Why should a retiree annuitize? Sharpe provides a simple example using Sue, a healthy 65-year-old retiree. Sue wants to set aside about $10,000 in bonds today to fund $20,000 of spending in 20 years. There’s a 70% chance that Sue will be alive in 20 years.
Why not get together with a large group of other 65-year-old female retirees and pool savings to fund the spending of the 70% who will still be alive in 20 years? Instead of saving $10,000, Sue can save $7,000.
The math gets even more compelling when Sue wants to fund spending in 30 years. Instead of setting aside $7,000 today, she can pool $2,400 with other retirees who collectively have a 34% chance of being alive. It’s a lot cheaper to fund the same income by pooling savings with other retirees and doling it out to whoever is still around in old age.
Despite their theoretical efficiency, Sharpe doesn’t let income annuities off the hook as an ideal source of safe retirement income. While they protect against longevity risk, annuities that provide a fixed nominal income are particularly susceptible to erosion in purchasing power late in retirement. The risk of annuities that are not inflation-protected is the drop in real spending from living too long and/or experiencing an inflationary period such as the late 1970s.
Sharpe notes that annuities that provide inflation protection are rare (outside of Social Security), and retirees may balk at the reduction in initial lifestyle required when an annuity pays a rising nominal income. Another caveat is that this decline in purchasing power may not be such a big deal if, as consumer spending data suggest, retiree spending needs decline in retirement.
Remember the 11% in expenses that are eaten up by a 1% AUM fee using the 4% rule? Sharpe tries to back out the expenses on simple annuity products by using mortality tables and current bond yields but finds no evidence that insurance companies are earning anything on the sale of these products.
This may sound impossible, but my co-researchers David Blanchett, Wade Pfau and I found the same thing when we tried to back out expense loads from annuity quotes using today’s bond rates. Sharpe’s explanation is that insurance companies typically invest a small percentage of reserves in higher-risk, higher-yield assets to earn a profit.
Either way, it’s hard to make the argument that simple income annuities are expensive. They may in fact be too cheap.
Of course, a downside of income annuities is that they invest in bonds resulting in a safer, but lower, expected income. What if an investor was willing to take a little more risk to increase the possibility of higher income while still avoiding the risk of running out of income late in life?
Variable Products
This the promise of the variable annuity with a somewhat unusual structure that provides a unique range of income paths in retirement. But how efficient is a variable annuity with a guaranteed lifetime withdrawal benefit rider? Sharpe uses a variable product available through Vanguard in his simulations, but the general results translate to other similar products.
One of the quirks of GLWB riders on VA policies is that they are what Sharpe terms “convenient but rather crude” where “simplicity seems to have outweighed actuarial imperatives.” The product being studied provides the same guaranteed withdrawal percentage within a wide range of ages.
This benefit is more valuable if you buy the annuity when you’re at the lower end of that range. For example, the product being studied provides a 4.5% guaranteed payout on a joint life GLWB for a couple who buys the product between ages 65 and 79.
For example, a VA policy with a GLWB rider will have fees roughly equal to the total present value of fees on a managed investment portfolio (about 11%) if a couple buys the product at age 79. However, if the same couple bought the product at 65, the youngest age of the 4.5% rate guarantee, the net present value of the rider fees would be negative 3%.
This is a head scratcher. Sharpe figures that the insurance company expects enough VA owners to withdraw more than the 4.5% minimum to reduce the value of the guarantee, but it also highlights the importance of understanding how insurance contract features affect value.
Running a handful of scenarios provides a good example of how these products work. The couple invests $100,000 at age 65 with a 4.5% joint GLWB.
In the worst scenario, markets fall early in retirement, and the couple simply lives on the $4,500 per year. In another scenario, income rises from $4,500 to $5,000 at year 8 and remains at this amount. In yet another scenario, markets rise slightly early in retirement, providing a ratchet up to about $6,000 in year 3 and never rises again. In one lucky scenario, the couple experiences a bull market early in retirement, and the income rises to $13,000 per year after 14 years.
Of course, the 4.5% income guarantee is not like the 4% rule, since it does not provide a stable after-inflation income throughout retirement. As an example, one simulated retiree got somewhat lucky as their income grew to just over $5,000 by year 5, but they also lived long enough to see the real value of their after-inflation income fall below $3,000. GLWB riders provide some random upside to lucky retirees and guaranteed income for life, but they don’t take away purchasing power risk for a long-lived retiree.
Sharpe’s conclusion is that the peculiar income ratcheting characteristic of GLWBs means that they are not any more efficient than the fixed withdrawal strategy. Many simulations result in low incomes that decline in purchasing power. But this isn’t because of greedy insurance companies.
On average, the present value of fees on GLWB VAs is only 3.3% of the initial value invested. And only 5.5% goes unspent to the couple’s estate, meaning that more of the initial nest egg ends up being spent. Unfortunately, the downside of the product structure is that the range of income paths might not provide the highest expected welfare to the couple who aren’t willing to accept the wide range of lifestyles offered by the GLWB.
Maximizing Retirement Efficiency
How does a retiree choose the right balance of lifestyle and risk? What combination of investments and insurance products provides the best solution? How does a retiree eliminate the risk of ruin that comes with an investments-only fixed withdrawal approach, protect against inflation, and take an appropriate amount of investment risk?
One approach is to place the majority of retirement savings in an income floor. The floor should optimally be constructed by purchasing an inflation-protected annuity (a rare beast) or through a ladder of Treasury inflation-protected securities, known as TIPS, in which a portion of value at maturity can be spent and the remainder can be used to purchase a ladder of annuitized nominal income. For example, a retiree can invest in 20-year TIPS that will grow by 1% above inflation at today’s rates that at maturity are used to purchase an annuity whose value will not have been eroded by inflation over time.
The remainder could be invested in a leveraged equity ETF. If the leveraged equity portfolio rises beyond the initial allocation to risky assets (say 15%), then the surplus can be used to add income to the riskless floor. If the leveraged strategy fails, the retiree will simply live on the income floor. An unleveraged portfolio would allocate a higher percentage to equities but follow the same approach of gradually building the guaranteed income floor over time.
This strategy may be complex for retirees and even advisors to implement. Ideally, innovation in financial products will allow advisors to build a retirement income investment plan using more efficient products that provide the greatest income security with the right amount of upside potential.
It took decades for Sharpe’s vision of a low-cost internationally diversified market portfolio to gain wide acceptance. Hopefully, it won’t take decades for the industry to build a more efficient and simple retirement income solution.
Michael Finke is Chief Academic Officer of The American College of Financial Services and a regular contributor to Investment Advisor.
Bill Sharpe: Courtesy of The American College of Financial Services
